The Rational Investor

The rational investor analyzes information and data to find investments. Intuitive investors, however, use information but draw more on experience, rules of thumb, and pattern recognition.

The Efficient Market Theory (EMT) states markets are very efficient. They are the result of the collective actions of all the rational investors. This assumes everyone knows exactly what to do with the information. And, they are capable of acting on it immediately in a totally rational manner.

Does that sound like the real world to you?

What the EMT fails to recognize is human nature and emotions like fear and greed. Experiences vary, as do viewpoints and risk tolerance. Investors vary in their abilities to analyze the data and information that ultimately drive the markets.

The Not-So Rational Investor

The reality is, all investors make decisions that are susceptible to cognitive and behavioral biases. These biases can cause systemic mistakes that lead to trouble.

Whether the rational investor, the intuitive investor, or some combination of both, investors are prone to these biases. They sell when stock prices drop, fearing more loss. Or they buy when prices rise higher so they don’t miss out on further gains.

“Selling low and buying high” is not rational. Their emotions and biases overcome the “rational economic self.”

“Intuition represents a powerful pattern recognition capability that individuals have, drawing from their wealth of past experience. However, intuition can lead us astray,” says researcher and Professor Michael A. Roberto.

Investor Behavior and Bias

The point is, even if we “Learn to Invest from the Best,” our biases can derail their principles and methods.

So, a first step is to sort ourselves out so we can better use what we learn. Then you, the rational investor, won’t unknowingly undermine your own performance.

In “Stocks are the Best Investment,” we see the average long term returns in the stock market are attractive. Shouldn’t that alone assure the average investors will do well?

Peter Lynch’s Magellan Fund

Unfortunately, that’s not the case. Some of course do well, but, as it turns out, we can also be our own worst enemy.

Peter Lynch, author of “One Up on Wall Street” ran the Fidelity Magellan fund from 1977-1990. He delivered an outstanding 29% average annual return during that period.

Afterwards, Fidelity conducted a study of the fund. They found that the average investor in the Magellan Fund lost money during Peter Lynch’s tenure! How can that be?

According to Fidelity, investors withdrew from the fund during periods of poor performance. Then they would return to the fund after periods of good performance.

Think about that. A great fund isn’t performing well during a market swoon. The prices are down, so investors sell, perhaps fearing more losses. The market recovers, the great fund performs even better. And, the investors return and start buying when prices are higher.

They chase performance, often sometimes skipping from fund to fund. They leave declining funds and buy into rising funds.

The same happens with indvidual stock investors. They reduce stock holdings or abandon them altogether in down markets. This is at precisely the wrong time to sell, when stocks are on sale.

Then, they buy into rising markets, when stocks are more expensive. Again, precisely the wrong time.

Chasing performance and market timing results in not-so-rational selling low and buying high.

The DALBAR Study

The Fidelity Magellan Fund isn’t unique. DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) has measured the effects of investor decisions on returns. Their study covers a 30 year period ending on 12/30/16.

Like the Fidelity Magellan fund, DALBAR found the largest factors in investment success are more dependent on investor behavior than on the fund’s performance.

DALBAR also found that fund investors who hold on to their investments are more successful.

In 2016, the S&P 500 made gains of 11.96%, and the average equity mutual fund investor earned 7.26%. Investors underperformed the market by 4.70%.

This is not an exception either. Over the 30 year period ending on 12/30/16, the S&P 500 annualized return was 10.16%. The average equity mutual fund investor’s annualized return was 3.98%. That’s a performance gap of -6.18%.

The “Market Results vs Investor Results” table below converts this performance gap to dollars. Over a 40 year career period wealth is reduced by 80%. The three cases examined are investing $100, $500 and $1000 per month over a career.

Note: Return is compounded annually at the end of each year.

DALBAR attributes individual investor underperformance to poor investor decision making and market timing. A short investment horizon (less than 4 years) is also cited.

Poor Decision Making

We like to think we are the rational investor. But studies show there are social, emotional, and cognitive factors that can unknowingly affect our decisions.

Over many thousands of years, humans were wired to quickly assess situations and react. These instinctive reactions worked well for survival in the wild.

However, for investing these instinctive reactions and biases can be counter-productive leading to poor decision making.

Common Investor Behavior Biases

Loss Aversion– A tendency to experience more discomfort with loss than happiness with gains. Studies show a loss is 2.5 times stronger than an equivalent gain. Investors tend to either act prematurely to avoid perceived losses or remember losses more, causing inaction to avoid more losses.
Herding– Herding is a tendency to conform to the larger group, whether those actions are rational or not. Investors buy when the markets are high and sell when they are low because that’s what everyone else is doing, even if it is not in their best interest.
Recency Bias– A tendency to place more weight on what happened recently. The stock market decline after the financial crises kept investors from the stock market, some for years, missing many years of attractive gains.
Confirmation Bias– A tendency to be drawn to information or ideas that validate existing views or beliefs and ignore information contrary to your beliefs. If you believe the market will rise or fall you gravitate to information that supports your perspective.
Mental Accounting– The tendency to treat money differently based on its source. Windfalls like inheritance or lottery winnings are more prone to be spent on luxuries instead of saved like earned income.
Media Response– A tendency to react to the news without further research or examination of the pros and cons, or the duration of the news’ impact on investments.
Anchoring– A bias for the first information received. If a first item costs $1,000 and a second $800, the second one is thought inexpensive relative to the anchor although it too may also be expensive. The anchor influenced your opinion.
Optimism– A tendency to overestimate the upside and underestimate the downside. Overestimating the upside can encourage decisions prematurely or excessively.

The Rational Investor’s Antidote is Self-awareness

I belong to an investment group where we exchange investment ideas with each other. The members are experienced investors successful in life and careers. Although experienced and thoughtful investors we all demonstrate these biases from time to time.

Investment success requires self-awareness to sort out these inherent biases in all of us. The rational investor must recognize both weaknesses and strengths to eliminate the largest obstacle to our investment success: ourselves.

“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. You need to keep raw irrational emotion under control.”

– Charlie Munger, Vice-Chairman, Berkshire Hathaway

Investment Advisors

So, why not just tap into an advisor with the experience and skills to control these behavioral biases? Aren’t they trained as the rational investor? Well, they’re human too and subject to the same biases.

And, if you find one that’s very rational, you still have to deal with yourself. Peter Lynch was an outstanding investment manager who generated a 29% annual return. However, it was his clients’ independent behavior that caused them to lose money.

There’s no way around it. Investment success requires self-awareness to mitigate these biases.

Simple But Not Easy

Simple but not easy is the way we described this in “Welcome to the Journey.” You will likely need to change yourself, those around you, and how you think about money.

Investing is simple in that it requires common sense, basic math skills, and patience. It’s not easy because it requires the discipline to keep emotions and biases out of investment decisions.

“Investing is not supposed to be easy. Anyone who finds it easy is stupid.” — Charlie Munger

Summary and Conclusions

Studies show there are social, emotional, and cognitive factors that can unknowingly affect investing decisions.
Investment success requires self-awareness to offset behavioral bias that can lead to costly problems over time.
It’s simple if we listen to the world-class investors who already did the heavy lifting and willingly share what they learned.
It’s not easy because a large factor in investment success requires humility and discipline to keep emotions and biases out of investment decisions.
Self-awareness and the principles, methods, and strategies of the best investor in the world will help mitigate these natural behavior biases. That’s why they’re the best, and you can be, too.